India Bond Yield: Is the risk reward favourable?

We believe investors today can achieve an attractive income in key bond segments by taking modest interest rate risk.

Bonds as an asset class has underperformed other traditional assets over the last one year, with the widely used bond benchmark - Crisil Composite Bond Index up ~7 percent, compared to equities (~27 percent), gold (~18 percent) and cash (~7 percent) (Data as of May 24, 2024). Bond yields have traded flat over the last year, as the RBI kept policy rates on hold for six consecutive meetings after raising rates by 250 bps to 6.50 percent in FY 2023. (Note: Bond yields and bond prices move in opposite directions). Bond mutual fund categories has underperformed cash with duration funds across short to medium and long duration lagging other bond categories.

Risk-reward turning favourable for bonds

The Indian economy has endured the impact of rapid monetary policy tightening better than its peers given superior macro fundamentals. India’s FY 2024 GDP growth is expected to be about 7.5 percent, while inflationary pressures (FY 2024 Avg CPI: 5.4 percent) has trended below the RBI’s upper-bound target of 6 percent. In our view, this macro backdrop is likely to continue in the coming year with domestic growth to stay above its long-term trend growth of 6.5 percent and ahead of its major peers. Resilient domestic demand, supportive government policies and continued focus on capex are tailwinds for growth in the coming year ahead. On inflation, the outlook is likely to be better than the last year with CPI trending closer to the RBI’s medium-term target of 4 percent. Though, a surge in oil prices and weather-related uncertainty can create inflation risks, ensuing disinflationary momentum in core-inflation and government’s readiness to intervene on the supply-side is likely to help contain the impact of volatile food and energy prices. In our assessment, given the above underlying strong growth conditions and contained inflation, the RBI is likely to commence its easing cycle in the latter half of 2024. Nevertheless, the rate easing cycle is likely to be shallower compared to previous easing cycles.

The above macro framework is favourable for bond investors with an attractive yield on offer and added prospects of capital gains as central banks globally are likely to commence their easing cycle later this year. We expect bonds to outperform cash, with the Indian government bond yields likely to range between 6.50 percent-6.75 percent over the coming 6-12 months. In addition, two factors have turned favourable for bonds. First, bond valuations are fairer, post the strong rally in equities with bonds’ relative value to equities improving. In addition, Indian bonds’ real yields (net of inflation) remains attractive compared to their Emerging Market (EM) peers. Second, the demand outlook for Indian onshore bonds is set to significantly improve following India’s inclusion in global bond index, starting June 2024. This inclusion is a boost for sustainable inflows into bond market, with a potential $20-25bn inflows annually over the coming few years. The impact is positive for India’s external balances supporting Rupee stability over the medium-term, which is a key consideration for offshore bond investors.

Attractive yield and tactical opportunities within bonds

We believe investors today can achieve an attractive income in key bond segments by taking modest interest rate risk. Having a diversified bond allocation with a mix of the below strategies would be key for bond investors:

* We prefer corporate bonds over government bonds, especially high-quality (AAA-rated) corporates given (a) an attractive absolute yield on offer, (b) narrowing of current credit spreads amid improving corporate profitability and strong demand for bonds from high-quality issuers and (c) lower sensitivity of corporate bonds to changes in RBI’s policy rates.

* We are positive on duration over the coming 12-18 months. The yield on offer is high with absolute yield close or above their 10-year average with the potential for higher price gains as yields fall given the increasing likelihood of the RBI lowering rates by 50-75bps over the next 12-15 months.

* Dynamic bond strategies are a tactical opportunity and provide investors better accruals, while helping in actively manage duration risk.

Nonetheless, it is important for investors to be wary of the risks. We see three risks over the medium-term: 1) Fiscal deficit is likely to remain elevated over the medium-term, 2) Tight banking system liquidity amid a lack of outright support from the RBI and 3) Above-average inflation is likely to keep bond yields elevated as rate cuts by the RBI and the US Fed gets pushed back. Finally, history shows us that something ‘breaks’ when rates are so high. We would remain cautious on going down the credit curve.

Vinay Joseph is the Director, Head – Investment Products and Strategy, Standard Chartered Wealth, India.

Views are personal and do not represent the stand of this publication.